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Review of Accounting Studies

, Volume 23, Issue 3, pp 1005–1041 | Cite as

Debt contracts in the presence of performance manipulation

  • Ilan Guttman
  • Iván Marinovic
Article
  • 379 Downloads

Abstract

Empirical evidence suggests that firms often manipulate reported numbers to avoid debt covenant violations. We study how a firm’s ability to manipulate reports affects the terms of its debt contracts and the resulting investment and manipulation decisions that the firm implements. Our model generates novel empirical predictions regarding the use and the level of debt covenant, the interest rate, the efficiency of investment decisions, and the likelihood of covenant violations. For example, the model predicts that the optimal debt contract for firms with relatively strong (weak) corporate governance (i.e., cost of manipulation) induces overinvestment (underinvestment). Moreover, for firms with strong (weak) corporate governance, an increase in corporate governance quality leads to tighter (looser) covenant, more (less) frequent covenant violations and lower (higher) interest rate. Our model highlights that the interest rate, which is a common proxy for the cost of debt, neither accounts for the distortion of investment efficiency nor the expected manipulation costs arising under debt financing. We propose a measure of cost of debt capital that accounts for these effects.

Keywords

Asymmetric information Debt contracts Earnings management 

JEL Classification

D82 D86 G3 M12 

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Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Stern School of BusinessNew York UniversityNew YorkUSA
  2. 2.Stanford Graduate School of BusinessStanford UniversityStanfordUSA

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